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Concepts & Tutorials

Bond Markets, Inflation, Policy Action And the Lag Effect

This comes from two comments to my last post asking me how active bond markets or the lack thereof affect the policy reaction to inflation. I’m not an expert so please feel free to correct me if I’m wrong.

Inflation is bad. To control inflation you need to increase interest rates. The concept is to slow down demand for money (and thus, reduce demand for other goods which fuels inflation) TO do that, money must become more expensive – that’s why the interest rate hike.

In an active bond market, all bonds are directly or indirectly benchmarked to the RBI interest rate. Companies will finance themselves using short term bonds – one week to a month types – and roll them over. Banks will lend long term and buy short term etc. The impact of an interest rate hike is immediate in this case – companies will see the impact of the rate increase. So short term borrowings will immediately be more expensive, increasing the cost for those that borrow short term, who will have to raise prices or take a profit hit.

Additionally the rate increase will cause the market value of longer term bonds to fall (since yields have gone up, the bond prices will go down). The m2m regulations will cause the holders of such bonds to take a little bit of a loss meaning they don’t have so much more money to invest either (which in a small way reduces the money supply some more)

So bond markets provide a market value for loans, both short and long term, and the fact that interest rate hikes immediately affect this market, will immediately affect all participants. The wider and deeper (in value) this participant base is, the faster the impact of an interest rate hike is on reducing demand for money and therefore in containing inflation. But when I say “immediate” it still means maybe 3 months.

Without an active bond market, you have to wait till the consumer sees the hit. Meaning, a bank has to raise rates (which as we’ve seen they are loathe to do, sensing that customers may default if it gets too bad) Once a bank raises rates, the corporate and retail customers will have to slow down demand.

The effect of this, given these are largely longer term loans, is slow. And since there isn’t a market value of these loans, there is no valuation either, a smaller problem. The change in demand for money will be visible in a longer time frame, maybe 6-12 months.

Even with active bond markets, Paul Volcker had to raise interest rates to 16% in the 70s in the U.S. to contain inflation – the darn thing was out of control. In the process, he ran the country through two recessions. Imagine if you were holding a 12% bond and thought – this is great. In a year it’s market value was lower because the interest rates had gone to 16%!

It was so bad that even Paul Krugman, the famous analyst, got it wrong. In 1982, he predicted that inflation was coming back and that interest rates would rise further – they fell a huge amount from there.

An active bond market can save the government’s backside when it comes to controlling runaway inflation, like in current times. Unfortunately now raising rates is like trying to use a vacuum cleaner to pull down a balloon that’s flying away – you gotta keep getting bigger capacity suction before it impacts the balloon. In this context, an active bond market is like a loose rope tied to the balloon, the other end of which is in your hand. You tighten, it responds, and you probably don’t need to increase suction that much.

If we are to tame this kind of inflation, interest rates need to be ABOVE inflation. RBI rates at 8.25% are not enough – and given the lack of a bond market it will need to go to 15% before inflation, at this level, is controlled. It will be much more difficult if it crosses 12-13%.

I hope my feeling about crude post July comes true. I believe supply will be much better in September, and demand for petro products is already going down considerably. If we crush the dollar, we won’t need to raise interest rates any more. We have 314 billion dollars, for heavens sake can someone go and beat the dollar down already? It’s far far far cheaper than hiking interest rates.

Note: this comes from a person who is a computer engineer and who, until last year, made his wages in an export oriented industry. Yes, a falling dollar will destroy this industry – but it’s better for the nation, and we can still earn export income by going higher up the chain and doing stuff other people want, rather than doing stuff other people don’t want to do.

Disclosure: No position because there are no active bond markets. (Hint, hint)

  • prax says:

    >Very informative, after sufficient read up i was also getting to a similar conclusion.

    One Question – do u buy the Austrian business cycle theory and does it gel with the current situation

  • Chaitanya says:

    >Thanks Deepak. That clarifies things. If i understood correctly interest rates are raised so as to make companies increase prices which will bring down demand and prices with it. It seems paradoxical that to decrease inflation we have to first increase it even more!

    -Chaitanya

  • hari says:

    >Nice post deepak.
    That analogy between balloon and vacuum cleaner was exceptional.I was suggesting the same thing of selling dollars to my colleagues, but all of them are telling that the RBI cannot sell Dollars beyond a certain point.Is it correct?

    Also if the dollar shoots up again after selling them what will happen then will inflation not creep back up again?

    Regards
    hari